The Truth About Trusts To Trust or not to Trust: That is the Question

Transcription

1 The Truth About Trusts To Trust or not to Trust: That is the Question Tim Mezhlumov, EA Melissa Simmons, CPA, EA Presented to North Texas Chapter of EAs, August 5, 2017

2 What is a Trust? A. A trust is traditionally used for minimizing estate taxes and can offer other benefits as part of a well-crafted estate plan. B. A trust is a fiduciary arrangement that allows a third party, or trustee, to hold assets on behalf of a beneficiary or beneficiaries. C. Trusts can be arranged in many ways and can specify exactly how and when the assets pass to the beneficiaries.

3 What is a Trust? D. Since trusts usually avoid probate, your beneficiaries may gain access to these assets more quickly than they might to assets that are transferred using a will. Additionally, if it is an irrevocable trust, it may not be considered part of the taxable estate, so fewer taxes may be due upon your death. E. Assets in a trust may also be able to pass outside of probate, saving time, court fees, and potentially reducing estate taxes as well.

4 What is a Trust? F. Other benefits of trusts include: 1. Control of your wealth. You can specify the terms of a trust precisely, controlling when and to whom distributions may be made. You may also, for example, set up a revocable trust to that the trust assets remain accessible to you during your lifetime while designating to whom the remaining assets will pass thereafter, even when there are complex situations such as children from more than one marriage.

5 What is a Trust? 2. Protection of your legacy. A properly constructed trust can help protect your estate from your heirs creditors or from beneficiaries who may not be adept at money management. 3. Privacy and probate savings. Probate is a matter of public record; a trust may allow assets to pass outside of probate and remain private, in addition to possibly reducing the amount lost to court fees and taxes in the process.

6 Creating Trusts Created when a donor transfers property to a fiduciary or trustee for the benefit of one or more beneficiaries Trust property is called corpus or principal A trust may be: Revocable: This type of trust may be changed by the grantor at any point during his or her lifetime. Irrevocable: This type of trust may be created either by will (testamentary trust) or by the grantor during his/her lifetime (inter-vivos).

7 Basic Types of Trusts Marital or A trust: Designed to provide benefits to a surviving spouse; generally included in the taxable estate of the surviving spouse Bypass or B trust: Also known as credit shelter trust, established to bypass the surviving spouse s estate in order to make full use of any federal estate tax exemption for each spouse

8 Basic Types of Trusts Testamentary Trust: Outlined in a will and created through the will after the death, with funds subject to probate and transfer taxes; often continues to be subject to probate court supervision thereafter Irrevocable life insurance trust (ILIT): Irrevocable trust designed to exclude life insurance proceeds from the deceased s taxable estate while providing liquidity to the estate and/or the trusts beneficiaries.

9 Basic Types of Trusts Charitable lead trust: Allows certain benefits to go to a charity and the remainder to your beneficiaries. Charitable remainder trust: Allows you to receive an income stream for a defined period of time and stipulate that any remainder to a charity Generation-skipping trust: Using the generation-skipping tax exemption, permits trust assets to be distributed to grandchildren or later generations without incurring either a generation-skipping tax or estate taxes on the subsequent death of your children.

10 Basic Types of Trusts Qualified Terminable Interest Property (QTIP) trust: Used to provide income for a surviving spouse. Upon the spouse s death, the assets then go to additional beneficiaries named by the deceased. Often used in second marriage situations, as well as to maximize estate and generation-skipping tax or estate tax planning flexibility

11 Basic Types of Trusts Grantor Retained Annuity Trust (GRAT): Irrevocable trust funded by gifts by its grantor; designed to shift future appreciation on quickly appreciating assets to the next generation during the grantor s lifetime Qualified Disability Trusts: Non-grantor trust created solely for the benefit of a disabled individual under age 65. All the beneficiaries of the trust as of the close of the taxable year are determined by the Commission of Social Security to have been disabled (within the meaning of section 1614(a)(3) of the Social Security Act, 42 U.S.C. 1382c(a)(3)) for some portion of such year.

12 Basic Types of Trusts Electing Small Business Trust (ESBT): An ESBT is a statutory creature established by Congress in the Small Business Job Protection Act of 1996 (P.L ). A trust may own S Corporation shares if it meets the requirements of an ESBT. A trust may qualify as an electing small business trust and as an S Corporation shareholder even if the trustee does not distribute all of the trust s income annually to its beneficiaries. An election must be made to be treated as an ESBT.

13 Basic Types of Trusts Grantor type trust: A grantor trust is one in which the creator (or grantor) retains some power or interest over the income and/or corpus of the trust. Created by a living individual, group of individuals, or other entity, this type of trust is not recognized as a separate taxable entity apart from its grantor for income tax purposes. Therefore, income earned by the assets of the trust is directly reported on the grantor or owner s income tax return. Accordingly, the grantor is deprived of any possible income tax advantages that might occur if the trust were taxed separately, such as lower marginal tax rates and a standard exemption amount.

14 Basic Types of Trusts Qualified Funeral Trust (QFT): A qualified funeral trust arises as a result of a contract with a person engaged in the trade or business of providing funeral or burial services or property necessary to provide such services. The sole purpose of the trust is to hold, invest, and reinvest funds in the trust and to use such funds solely to make payments for such services or property for the benefit of the beneficiaries of the trust. The only beneficiaries of QFTs are individuals with respect to whom such services or property are to be provided at their death under the contract. The only contributions to the trust are contributions by or for the benefit of such beneficiaries. The trustee of the trust must make an election to be treated as a QFT.

15 Basic Types of Trusts Split-Interest Charitable Trusts: Splitinterest means that the interest in the property is split into two parts: an income interest and a remainder interest. The income interest is separate from the remainder interest. Both interests can be assigned to a charity of charities, one or more non-charitable beneficiaries, or both depending on the type of splitinterest charitable trust.

16 Basic Types of Trusts In Addition, charitable trusts engaging in business activities but organized to benefit charities are subject to the rules on unrelated business income. Based on the method and timing of distributions, split-interest charitable trusts are divided into the following four categories:

17 Basic Types of Trusts 1. Charitable remainder annuity trusts: Distribute income in a series of fixed payments to one or more non-charitable beneficiaries for a defined period of time, after which the remaining value of the trust is transferred to a charitable beneficiary. 2. Charitable remainder unitrusts: Distribute a percentage of the fair market value to one or more non-charitable beneficiaries for a defined period of time, after which remaining value of the trust is transferred to a charitable beneficiary.

18 Basic Types of Trusts 3. Charitable Lead Trusts: Distribute a sequence of payments to a charitable beneficiary for a period of time, after which the remaining trust assets are transferred to a non-charitable beneficiary. 4. Pooled Income Funds: Allow donors to donate assets to a charity. The pooled assets are invested as a group and each donor receives income based on the ration of his or her contribution to the total value of the investment pool. After the death of the donor, his or her prorated share of the investment pool is withdrawn and given to the charitable organization.

19 Basic Types of Trusts Pet Trusts: A legally sanctioned arrangement providing for the care and maintenance of one or more companion animals in the event of a grantor s disability or death. Miller Trust: A Miller Trust makes Social Security and other income exempt from calculations of income and resources if the state is reimbursed from the trust for Medicaid expenses upon the recipient s death.

20 Benefits of Generation-skipping Trust Not just for the wealthy: This type of trust provides a great way to safeguard any family s assets from excess tax, creditors and ex-spouses looking for their share of the estate. Good choice for wealthier families to be able to transfer their assets from the older generation to their grandchildren or great grandchildren without making their assets vulnerable to estate or so-called death tax.

21 Benefits of Generation-skipping Trust Allows all descendants to benefit the most from assets in the trust without the harsh imposition of estate or death tax when the children die, and then again when the grandchildren pass away.

22 Benefits of Generation-skipping Trust Protects assets from second generation problems: 1. Let s assume that a child in the second generation has gone through a less than amicable divorce. Because the assets in the generation skipping trust won t legally belong to the exspouse, the divorcing spouse will never be able to claim a share of the trust s assets. 2. If a child starts a company and the company later goes under, the assets in the trust cannot be tapped into to pay the debts of the child as the child does not own the assets.

23 Benefits of Generation-skipping Trust 3. Protects assets from other financial catastrophes that may occur, such as an uninsured car accident or a large gambling debt 4. For a child that might be a spendthrift, this trust will allow the child to have access to trust assets but not be in control over the timing of distributions of those assets.

24 Generation-skipping Trust Limitations Limit that can be transferred is $2 million per person that can be left in the trust. Transfers to the trust can be made in amounts up to $1 million. Some professionals request their parents put their estates into a generation skipping trust. For example, a doctor who has an enhanced risk of liability may see the generation skipping trust as a way for his parent s estate to be protection from creditors while the assets are still available to him.

25 Revocability Donor control May be irrevocable Donor gives up control over property May be revocable Donor may revoke trust and take back property Treated as grantor trust with donor taxable on all income even if trust is not revoked

26 Separate Legal Entity Under State Law A trust must meet both state law and federal law requirements to be so recognized. The Internal Revenue Code contains no definition of a trust; only state law governs trusts. The trustor (grantor or settlor) is the person who transfers property to the trustee. The trustee then manages the property for the benefit of the beneficiaries named and distributes income and principal in accordance with the trust agreement.

27 Trusts - Nontax Purposes May get professional management through use of a corporate trustee, such as a bank Useful for providing for beneficiaries incapable of managing property, such as children Useful if lifetime beneficiaries are different from remaindermen Lifetime Beneficiary: Entitled to receive income and possibly principal from the trust property Remainderman: Entitled to receive a portion of the principal at termination of the life interest. Trusts may be useful in minimizing estate costs and can offer other benefits as part of a well-crafted estate plan.

28 Trusts Simple trust Trust required to distribute all of its accounting income Trust does not allow amounts to be paid, permanently set aside or used in the tax year for charitable purposes Trust does not distribute amounts from the principal of the trust (corpus) Complex trust Any trust that is not a simple trust

29 Simple vs. Complex Trusts A. An irrevocable trust may be either simple or complex. B. The terms simple and complex are not found in the Internal Revenue Code. C. They are, however, to be found in the regulations and on the form 1041 tax return and instructions and are frequently used in practice.

30 Simple vs. Complex Trusts D. For a trust to qualify as a simple trust in any year, it must meet all three of the following criteria ( ) 1. The trust requires that all fiduciary accounting income must be distributed currently to the beneficiaries; and 2. The trust does not make charitable contributions; and 3. The trust does not distribute principal.

31 Simple vs. Complex Trusts E. The phrase all accounting income be distributed currently means that all fiduciary accounting income is required by the terms of the trust instrument to be distributed in the year that it is received. F. The trustee must be under a duty to distribute the income currently. G. The fact that the actual distribution is not made until after the close of the taxable year does not eliminate status of a simple trust.

32 Simple vs. Complex Trusts H. If the trust requires all income to be distributed currently, then it is deemed to have been distributed (Reg. 1.65(a)-2). I. If the trust does not qualify as a simple trust, then it is, by definition, a complex trust ( ). The distinction is important in computing the distribution deduction for the trust.

33 Worksheet Simple vs. Complex Trust Determination For a trust to qualify as a SIMPLE TRUST, all answers to the following questions MUST BE YES IRC The Trust requires that all fiduciary accounting income must be distributed currently Yes No 2. The trust does not allow amounts to be paid, permanently set aside or used in the tax year for charitable purposes 3. The trust does not distribute amounts from the principal of the trust If you answered NO to ANY of the above Questions, the trust does not qualify as a simple trust. It is a COMPLEX TRUST, IRC , for the current year.

34 Charitable Trusts Complex Trusts Have charitable and non-charitable beneficiaries Charitable Remainder Trust Charity gets the remainder at the end of trust term Charitable Lead Trust Charity gets income during trust term

35 Tax Professional Alerts To attempt to prepare a trust tax return (form 941) the tax professional needs a minimum of two documents, the Last Will and Testament and the Trust Agreement. A trust can be a simple trust one year and a complex trust the next year All trusts will be treated as complex trusts in the final year, as the trust must distribute principal at the time of the final return. An election can be made for a qualified revocable trust (QRT) to be treated as part of and estate (IRC 645). A QRT is a trust, or portion of a trust, treated as owned by a decedent because the decedent had the power to revoke the trust on the date of death. (See form 8855)

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37 Trust Filing Requirements Any taxable income for the tax year Gross income of $600 or more (regardless of taxable income) A beneficiary who is a nonresident alien

38 Trust Due Date Trusts must use a calendar year unless the trust is treated as wholly owned by a grantor, or falls under IRC section 501(a) tax-exempt trusts and IRC section 4947(a)(1) charitable trusts. Deadline is the 15 th day of the fourth month after the close of the tax year, ie April 15 th?? Extensions are granted for 5 ½ months using form 7004

39 States with Inheritance Tax Connecticut Delaware District of Columbia Hawaii Illinois Iowa Kentucky Maine Maryland Massachusetts Minnesota Nebraska New Jersey New York Oregon Pennsylvania Rhode Island Tennessee Vermont Washington

40 Trust Accounting Income Importance: determines the amount paid to income beneficiaries each year. Categories of income (interest, dividends, capital gains, etc.) and expenses are assigned to income or principal. If trust document is silent on allocation, state law controls, usually determined by the state s principal and income act. cs/pr/htm/pr.116.htm

41 Common Allocations Income Interest, dividends, rents, royalties Operating income Operating expense Taxes levied on income Principal Capital gains and losses on investments Casualty losses and insurance recoveries Extraordinary repairs Taxes levied on principal

42 Example of Accounting Income Income and Expenses Accounting Income Interest $ 3, $ 3, Dividends $10, $10, Capital Gains $ 7, $ -0- Trustee Fees $(2,000.00) $(1,000.00) Tax Preparation $ (400.00) $ (200.00) $17,600 $11,800.00

43 Trust Taxable Income Computed in a manner similar to individual taxable income No adjusted gross income concept No standard deduction

44 Trust Taxable Income Calculation Step 1: Calculate trust accounting income Step 2: Calculate trust taxable income before income distribution deduction Step 3: Compute distributable net income (DNI) and the distribution deduction Step 4: Subtract the distribution deduction from the amount in step 2 to determine trust taxable income

45 Trust Taxable Income Calculation (continued) Step 5: Calculate trust tax liability Step 6: Allocated DNI and the distribution deduction to the beneficiaries to determine the amount and character of income taxed to each beneficiary

46 Depreciation May be deductible by trust, beneficiaries or allocated between them Trust document controls If document silent, depreciation apportioned based on share of trust accounting income In such a situation a simple trust would allocate all depreciation to beneficiaries

47 Other Expenses Any expense attributable to earning taxexempt income is nondeductible Indirect expenses such as trust administration fees must be allocated between taxable and tax-exempt income based upon their proportion of total income

48 Example of Tax-Exempt Allocation of Expenses Total Income Accounting Income Interest & Div $ 4, $ 4, Rental Income $14, $14, Muni Bond interest $ 6, $ 6, Gross $24, $24, Capital Gains $ 7, $ -0- Rental Expenses $(9,000.00) $(9,000.00) Trustee Fees $(3,000.00) $ (750.00) Rental expenses are directly allocable to taxable income and are deducted in full. Trustee Fees of $3,000 must be allocated: $3000 expense x $6,000 tax-exempt interest/$24,000 Gross accounting income = $750 Reduction Line 12 (form 1041) deduction = $3,000 - $750 = $2,250 Capital gains are included in gross accounting income only if allocated to income.

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50 Exemptions All trusts entitled to a personal exemption except in final year Trusts required to distribute all income annually receive an exemption of $300 Other trusts receive $100 exemption

51 Distributable Net Income (DNI) Defines the maximum possible income distribution deduction and maximum possible income from trust taxable to beneficiaries Distributable does not necessarily means that it was actually distributed Trust document may dictate distributions Examples: minors, spendthrift, incapacitation

52 Distributable Net Income Calculation Start: Add: Taxable income before distribution deduction Personal exemption Subtract: Capital gains allocated to principal Add: Add: Capital losses allocated to principal Tax-exempt interest Subtract: Expenses allocated to tax-exempt income

53 Trust Tax Liability Tax rates are steeply progressive reaching the maximum rate of 39.6% with only $12,500 of taxable income in 2017 Often beneficiaries are in lower rate brackets

54 Additional Tax Liability 3.8% surtax applies to lesser of: 1) undistributed net investment income or 2) excess of AGI over $12,500 (2017)

55 Character of Income If more than one type of income is distributed from a complex trust, it must be allocated proportionately among income beneficiaries

56 Trust Property Distributions Property passes out at its adjusted basis Trust does not recognize gain or loss on distribution Beneficiary takes carryover basis Holding period tacks

57 Trust Property Distributions At the option of the trustee, the trust may elect to recognize gain on distributions of appreciated property Distribution treated as made at fair market value to beneficiary Holding period begins on date of the distribution

58 Questions?? Contact information: Melissa Simmons Some of the material used for this presentation was taken from NCPE, National Center for Professional Education, Inc. and NCPE Fellowship s 2017 presentation of What s Happening in the World of Tax. Permission granted by Beanna Whitlock, EA.